Payback Period in Project Management: Formula & Examples

Payback period analysis is still one of the most popular techniques to evaluate your investments.

In this article, we’ll provide the most important basics for understanding the payback period in project management: formula, examples, and pros and cons.

Key Takeaways

The payback period, in simple terms, represents the amount of time needed to recoup the costs of your initial investment.

Payback period is a popular evaluation criteria when businesses need to decide if they want to go ahead with a certain project or investment.

Usually, a shorter payback period is preferred, since it means that the business will start recovering costs faster.

However, the biggest downside of the payback period method is that it doesn’t take the time value of money into account (the principle that the value of cash doesn’t stay the same throughout years).

However, there are some other options that correct this downside—the discounted payback period formula—which we’ll discuss later in the article.

The simplest formula for calculating the payback period is the so-called averaging method:

While this formula is popular due to being easy to use and understand, it doesn’t take into account that cashflows might vary over the years.

For that, you’ll need to use the subtraction method. Subtract each year’s cash flow from the initial investment until zero is reached. This can be considered the amount of full years until recovery.

If we put this into a formula, it would look something like this:

So, if we’re using the simplest averaging method to calculate cash returns, here’s what this might look like:

A company invests $50,000 in a new project. The business is expected to generate an average annual cash flow of $10,000.

Using the averaging method formula, we get:

So, the period for making up the upfront investment would be five years.

You can see the appeal of this method, as it’s very simple and straightforward. But, what if the annual cash inflow isn’t stable?

Let’s take the example as above where $50,000 is invested, but the annual cash flows are inconsistent: Year 1: $12,000; Year 2: $15,000; Year 3: $13,000; Year 4: $10,000.

To get to the amount of years where the initial investment is recouped, you’ll need to subtract the varying cash flows from the initial investment:

So, at the end of year four, you’ll be at a break-even point.

To get the full amount of years until payback, you can use the formula:

While this brings us to the same result, there can be significant differences between the results in these two methods, depending on how uneven cash flows are.

While we’ve seen how the formula can be adjusted to take into account the changes in future cash flows over the years, there’s still a flaw in the calculations: the value of money changes over a period of time.

There’s a way to adjust this formula by using the discount rate, or the interest rate used to determine the present value of future cash flows.

So, if the discount rate is 5%, and we take the example of the cashflows from above, here’s what they would look like:

If we were to rerun, the calculation from above with the discounted cash flows, the final result would look like this:

So, by the end of year 4, you still wouldn’t have recouped costs, meaning that the payback period is 5+ years.

While this calculation is more accurate, getting the discount rate right usually requires advanced financial analysis expertise.

A good payback period depends on industry standards and risk tolerance. Generally, a time period of three to five years is considered acceptable for most investments. Shorter periods indicate a lower risk, so businesses prefer faster payback to improve cash flow and reduce uncertainty.

What makes this method so popular in corporate finance, to the point where it’s estimated that about 50% of companies are using it (Boyle and Gunhrie, 2006), despite its flaws?

Here are the main pros:

Here’s a summary of the main cons of this method:

Some of these downsides are mitigated by adjusting the formula, as we’ve depicted in the examples above.

Others can be addressed by using it as a preliminary step in your analysis; you find the proposals with the shortest payback period, and then use methods such as NPV vs IRR for more in-depth insights.

So, here’s an overview of different metrics that are useful to apply in your business financial toolkit, and their main differences:

Net Present Value (NPV) considers the present value of future cash flows by discounting them to today’s dollars. A positive NPV, expressed in dollar terms, means that the investment is expected to generate positive return, and a negative one means that the original investment is likely to lose value.

NPV is superior for long-term decision-making because it accounts for both cash flow timing and risk, while the payback period focuses only on short-term liquidity.

Internal rate of return is a profitability metric that calculates the discount rate at which the net present value (NPV) of an investment’s future cash flows equals zero. It represents the annualized return an investment is expected to generate, incorporating the time value of money to assess long-term profitability.

While the payback period only determines how quickly an investment is recovered, IRR considers the full life cycle of cash inflows.

The Break-Even Analysis identifies the point at which total revenue equals total costs, meaning no profit or loss occurs.

Unlike the payback period calculation, which determines how long it takes to recover an investment, break-even focuses on operational profitability by determining the sales volume required to cover fixed and variable costs. It is widely used for pricing strategies, cost control, and sales forecasting.

Both tools help businesses assess financial viability but serve different strategic purposes.

To summarize, payback analysis is one of the main strategies for investment appraisal.

While it’s a simple method, it’s shown by research to be effective in companies of various types and sizes. It can also be used as part of a more in-depth analysis, when combined with other capital budgeting methods and metrics.

Another useful way to manage data, especially for businesses that work with clients, is to use a project management software solution with financial management features.

With Productive, businesses can forecast their project’s profitability and revenue, compare different financial scenarios, allocate resources, and deliver projects while keeping full control over their business performance.

Book a demo with Productive to learn more.